Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^560) 16. Raising Capital © The McGraw−Hill
Companies, 2002
Typically, the underwriter buys the securities for less than the offering price and accepts
the risk of not being able to sell them. Because underwriting involves risk, underwriters
usually combine to form an underwriting group called a syndicateto share the risk and
to help sell the issue.
In a syndicate, one or more managers arrange, or co-manage, the offering. The lead
manager typically has the responsibility of dealing with the issuer and pricing the secu-
rities. The other underwriters in the syndicate serve primarily to distribute the issue and
produce research reports later on.
The difference between the underwriter’s buying price and the offering price is called
the gross spread, or discount. It is the basic compensation received by the underwriter.
Sometimes, on smaller deals, the underwriter will get noncash compensation in the form
of warrants and stock in addition to the spread.^5
Choosing an Underwriter
A firm can offer its securities to the highest bidding underwriter on a competitive offer
basis, or it can negotiate directly with an underwriter. Except for a few large firms, com-
panies usually do new issues of debt and equity on a negotiated offer basis. The excep-
tion is public utility holding companies, which are essentially required to use
competitive underwriting.
There is evidence that competitive underwriting is cheaper to use than negotiated un-
derwriting. The underlying reasons for the dominance of negotiated underwriting in the
United States are the subject of ongoing debate.
Types of Underwriting
Two basic types of underwriting are involved in a cash offer: firm commitment and best
efforts.
Firm Commitment Underwriting In firm commitment underwriting, the issuer
sells the entire issue to the underwriters, who then attempt to resell it. This is the most
prevalent type of underwriting in the United States. This is really just a purchase-resale
arrangement, and the underwriter’s fee is the spread. For a new issue of seasoned equity,
the underwriters can look at the market price to determine what the issue should sell for,
and more than 95 percent of all such new issues are firm commitments.
If the underwriter cannot sell all of the issue at the agreed-upon offering price, it may
have to lower the price on the unsold shares. Nonetheless, with firm commitment un-
derwriting, the issuer receives the agreed-upon amount, and all the risk associated with
selling the issue is transferred to the underwriter.
Because the offering price usually isn’t set until the underwriters have investigated
how receptive the market is to the issue, this risk is usually minimal. Also, because the
offering price usually is not set until just before selling commences, the issuer doesn’t
know precisely what its net proceeds will be until that time.
Best Efforts Underwriting In best efforts underwriting, the underwriter is legally
bound to use “best efforts” to sell the securities at the agreed-upon offering price. Be-
yond this, the underwriter does not guarantee any particular amount of money to the is-
suer. This form of underwriting has become rather uncommon in recent years; firm
commitments are now the dominant form.
532 PART SIX Cost of Capital and Long-Term Financial Policy
syndicate
A group of underwriters
formed to share the risk
and to help sell an issue.
gross spread
Compensation to the
underwriter, determined
by the difference
between the
underwriter’s buying
price and offering price.
firm commitment
underwriting
The type of underwriting
in which the underwriter
buys the entire issue,
assuming full financial
responsibility for any
unsold shares.
(^5) Warrants are options to buy stock at a fixed price for some fixed period of time.
Learn more about
investment banks at
Merrill Lynch
(www.ml.com).
best efforts underwriting
The type of underwriting
in which the underwriter
sells as much of the
issue as possible, but
can return any unsold
shares to the issuer
without financial
responsibility.